externalities: pollution, education, and health care

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How can we limit climate change?

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9When you have completed your study of this chapter, you will be able to

1 Explain why negative externalities lead to inefficient overproduction and how property rights, pollution charges, and taxes can achieve a more efficient outcome.

2 Explain why positive externalities lead to inefficient underproduction and how public provision, subsidies, and vouchers can achieve a more efficient outcome.

CHAPTER CHECKLIST

Externalities: Pollution, Education, and Health Care

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An externality is a cost or a benefit that arises from:• Production that falls on someone other than the

producer• Consumption that falls on someone other than the

consumer

Negative externality

A production or consumption activity that creates an external cost.

Positive externality

A production or consumption activity that creates an external benefit.

EXTERNALITIES IN OUR DAILY LIVES

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Four types of externalities:

• Negative production externalities

• Positive production externalities

• Negative consumption externalities

• Positive consumption externalities


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Negative Production Externalities

Pollution is the major example of this type of externality.

Others are noise and congestion.

Positive Production Externalities

Example: Orchards provide positive production externalities to honey producers, who in turn provide positive production externalities to orchards.


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Negative Consumption Externalities

Smoking tobacco in a confined space

Noisy parties

Positive Consumption Externalities

Education is a major example of this type of externality.

Others are a flu vaccination and restoration of an historic building


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9.1 NEGATIVE EXTERNALITIES: POLLUTION

Private Costs and Social Costs

Marginal private cost is the cost of producing an additional unit of a good or service that is borne by the producer of that good or service.

Marginal external cost is the cost of producing an additional unit of a good or service that falls on people other than the producer.

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Marginal social cost is the marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls.

Marginal social cost (MSC) is the sum of marginal private cost (MC) and marginal external cost.

MSC = MC + Marginal external cost

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Figure 9.1 shows the relationship between cost and output.

When output is 4 million gallons of paint a month:

1. Marginal privatecost is $1.00 a gallon.

2. Marginal externalcost is $1.25 a gallon.

3. Marginal social cost is $2.25 a gallon.

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Production and Pollution: How Much?

When an industry is unregulated, the amount of pollution it creates depends on the market equilibrium price and the quantity of the good produced.

If the industry creates an external cost, the market equilibrium is inefficient. Too much of the good is produced.

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Figure 9.2 shows inefficiency with an external cost.

3. Marginal benefit.

2. Marginal social cost exceeds ...

1.The equilibrium price of $1.00 a gallon and 4 million gallons of paint a month is inefficient.

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4. The efficient quantity is 2 million gallons of paint, where marginal social cost equals marginal benefit.

5. The gray triangle shows the deadweight loss created by the pollution externality.

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Fixing the Inefficient Overproduction

Three ways of dealing with externalities that avoid the overproduction they bring are to

•Establish property rights.

•Mandate clean technology.

•Tax or price pollution.

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Establish Property Rights

Externalities arise when property rights are missing.

Property rights are legally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in the courts.

Establishing property rights is one way of dealing with externalities

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To see how property rights can work, suppose the paint producers own the homes and the river.

The rental income they can earn on the homes depends on the amount of pollution they create.

The effect of pollution on rental income gives the paint producers an incentive to limit pollution.

They might limit pollution by:•Using an abatement technology•Decreasing production

Firms will chose the least-cost alternative method.

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The Coase Theorem

Coase theorem is the proposition that if property rights exist, only a small number of parties are involved, and transactions costs are low, then private transactions are efficient and the outcome is not affected by who is assigned the property right.

Transactions costs are the opportunity costs of conducting a transaction.

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Application of the Coase Theorem• If polluting paint factories own homes and river, the rent people willingly pay decreases as the amount of pollution increases.

• If homeowners own the river, the factories must pay homeowners for any pollution, and the more the factories pollute, the more they pay.

• Regardless of who owns the river, so long as someone owns it, the factories bear the cost of pollution, and the quantity of production and pollution are efficient.

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Efficient Market Equilibrium With Property Rights

Figure 9.3 illustrates.

1. With property rights, the MC curve that excludes the cost of pollution shows only part of the producers’ marginal cost.

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2. The marginal private cost curve includes the cost of pollution, and the supply curve is S = MC.

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4. Marginal social cost equals marginal benefit.

3. Market equilibrium is at a price of $1.50 a gallon and a quantity of 2 million gallons of paint a month and is efficient because…

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Mandate Clean Technology

Governments regulate what may be dumped in rivers and lakes and emitted into the atmosphere.

The Clean Air Act of 1970 gives the Environmental Protection Agency the authority to issue regulations that require utilities, chemical plants, and steel mills to limit pollution.

Mandated limits are not likely to be the most efficient limits.

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Tax or Cap and Price PollutionGovernments use two methods to confront polluters with the costs of their decisions:•Taxes •Cap-and-trade

To work out the pollution charge or pollution tax that achieves efficiency, the regulator needs a lot of information about the industry, which is generally not available.

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Taxes

By setting the tax equal to the marginal external cost (or marginal abatement cost if it is lower), firms can be made to behave in the same way as they would if they bore the cost of the externality directly.

To see how a tax works, assume that the government has assessed the marginal external cost of pollution accurately and imposes a tax on the factories that exactly equals this cost.

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Figure 9.4 shows the effects of a pollution tax.

1. The pollution tax is imposed that is equal to the marginal external cost of pollution.

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The supply curve becomes the marginal private cost curve, MC, plus the tax—the curve labeled S = MC + tax.

Because the charge or tax equals the marginal external cost the supply curve becomes the MSC curve.

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2. Market equilibrium at a price of $1.50 a gallon and 2 million gallons of paint a month is efficient because…

3. Marginal social cost equals marginal benefit.

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4. The government collects revenue equal to the area of the purple rectangle.

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Cap-and-Trade

Cap-and-trade places a cap or ceiling on emissions and assigns or sells emission rights to individual producers who are then free to trade permits.

It is a tool that seeks to combine the power of government to limit total emissions with the power of the market to minimize cost and maximize benefit.

To use this method, the government must first estimate the efficient quantity of pollution, set the overall emissions cap to achieve the efficient outcome, and allocate the cap to producers.

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The market in permits determines the equilibrium price of emissions.

Each firm, confronted with that price, maximizes profit by setting its marginal pollution cost or marginal abatement cost, whichever is lower, equal to the market price of a permit.

By confronting polluters with a price of pollution, trade in pollution permits can achieve the same efficient outcome as a tax.

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9.2 POSITIVE EXTERNALITIES: EDUCATION AND HEALTH CARE

Private Benefits and Social Benefits

Marginal private benefit is the benefit of an additional unit of a good or service that the consumer of that good or service receives.

Marginal external benefit is the benefit of an additional unit of a good or service that people other than the consumer of the good or service enjoy.

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Marginal social benefit is the marginal benefit enjoyed by society—by the consumer of a good or service and by everyone else who benefits from it.

Marginal social benefit (MSB) is the sum of marginal private benefit (MB) and marginal external benefit.

MSB = MB + Marginal external benefit

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Figure 9.5 shows an external benefit.

When 15 million studentsattend college:

2. Marginal external benefit is $15,000 per student.

1. Marginal private benefit is $10,000 per student.

3. Marginal social benefit is $25,000 per student.


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Figure 9.6 shows inefficiency with an external benefit.

1. Market equilibrium is at a tuition of $15,000 a year and 7.5 million students and is inefficient because …

3. Marginal cost.

2. Marginal social benefit exceeds …


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5. The gray triangle shows the deadweight loss created because too few students enroll in college.

4. The efficient number of students is 15 million.


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Government Actions In the Face of External Benefits

Three devices that governments can use to achieve a more efficient allocation of resources in the presence of external benefits:

• Public provision• Private subsidies• Vouchers

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Public provision is the production of a good or service by a public authority that receives the bulk of its revenue from the government.

A subsidy is a payment that the government makes to private producers to cover part of the costs of production.

A voucher is a token that the government provides to households that can be used to buy specified goods or services.

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Figure 9.7 shows how public provision can achieve an efficient outcome.

1. Marginal social benefit equals marginal cost with 15 million students enrolled in college.

2. The efficient quantity.

3. Tuition is $10,000 per year.

4. Taxpayers cover the remaining $15,000 of marginal cost per student.

Public Provision


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Figure 9.8 showshow a subsidy achieves an efficient outcome of 15 million students.

1. A $15,000 subsidy per student shifts the supply curve toS = MC – subsidy.

2. The dollar price is $10,000 a student.

Private Subsidies


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4. Marginal social benefit equals marginal cost.

3. The market equilibrium is efficient with 15 million students enrolled in college.


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Vouchers

Figure 9.9 shows how vouchers can achieve an efficient outcome.

The MSB curve becomes the demand curve because…

1. With vouchers, buyers are willing to pay MB plus the value of the voucher.


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3. Price, marginal social benefit, and marginal cost are equal.

2. Market equilibrium is efficient with 15 million students enrolled.

4. Tuition equals the dollar price of $10,000 plus the value of the voucher.


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Economic Problems in Health-Care Markets

Health care is two distinct products:

1. Health insurance—insurance that pays health-care bills

2. Health-care services—the services of health-care professionals and hospitals.

With no government intervention, both health insurance and health-care services would be underprovided.

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Health insurance and health-care services would be underprovided for three economic reasons:

• Asymmetric information

• Missing insurance market

• Public-health externalities

Asymmetric Information

Asymmetric information brings adverse selection and moral hazard to both these markets.

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Adverse selection occurs when a seller is better informed than a buyer or a buyer is better informed than a seller, and the deal that gets made benefits the one who is better informed.

Moral hazard arises after a deal is done when the actions of the person with private information impose costs on the uninformed party.

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In the health insurance market:

Adverse selection arises because some of the healthiest people choose to be uninsured, at least during their younger years.

Moral hazard arises because once insured, a person has less incentive to adopt a healthy lifestyle and some will yield to the temptation to drift into unhealthy habits.

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In the market for health-care services:

Adverse selection arises because buyers are unable to assess quality reliably enough, so too few high-quality providers would enter the market.

Moral hazard arises because health-care service providers have an incentive to play safe and overtreat a patient.

Neither the patient nor the insurance company has information with which to prevent this inefficiency.

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Missing Insurance Market

Many people can’t get private health insurance because they are too old, too sick, or too disabled.

Others with pre-existing conditions can get insurance but only with exclusions of the very health problems they are most likely to encounter.

These people have the greatest wants for health care, but the least ability to get it in the free market.

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The missing insurance market is one that is blind to a person’s known health risks.

This market can only be provided by government intervention.

The U.S. system deals with this problem by government provision of health insurance—Medicare and Medicaid, which provides health insurance to 93 million people.

It is estimated that 48 million people have no health insurance and 25 million are underinsured.

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Public-Health Externalities

Infectious diseases have a negative externality. Marginal social cost exceeds the marginal private cost, so public sanitation systems overcome a deadweight loss that would be generated by these externalities.

Vaccination against an infectious disease has a positive externality. The marginal social benefit exceeds the marginal private benefit, so another reason to subsidize health care of the aged and those in poverty.

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12.3 HEALTH-CARE MARKETS

Health-Care Systems in Other Countries

Every major country except the United States has a comprehensive national health-care system.

Every person is insured under a government-funded national insurance program.

Health-care services are provided by private clinics, hospitals, physicians, and specialists but they are paid for by governments.

Government expenditure on health care is funded by health insurance taxes and income taxes.

12.2 INFORMATION PROBLEMS IN INSURANCE MARKETS

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Resources in the public health-care system are allocated by physicians, specialists, and hospitals and are based on urgency of need, which often results in lengthy waiting lists.

No one is permitted to opt out of the national health service but in most countries, everyone is permitted to buy private insurance and private health care.

So a “two-tier” system emerges in which the rich buy private insurance and get high-quality care while the poor get low-quality state care.

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A Reform Idea

Health care in the United States faces two problems:

Too many people are uninsured and health care costs too much.

Obama Affordable Care Act addresses the first of these problems but does little to address the overexpenditure.

A solution to both the problems is to use health-care vouchers to ensure universal coverage and put a cap on total expenditure.

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The average temperature of the Earth is rising and

so is the atmospheric concentration of carbon dioxide, CO2.

The figure shows these upward trends.

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Scientists debate the contribution of human economic activity to these trends, but most believe it to be a major source.

Economists debate the costs and benefits of alternative ways of slowing CO2 and other greenhouse gas (GHG) emissions, but most favor some action.

Economists agree that lowering greenhouse gas emissions requires incentives to change.

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One idea is to cap emissions and issue tradable emissions permits, a system called cap-and-trade.

The idea has backers and opponents in Congress although cap-and-trade has been used successfully by the EPA to cut local air pollutants.

The Congressional Budget Office estimates that in 2020, if GHG emissions were capped at 83 percent of their 1995 levels, the price of a permit to emit one ton of GHG would be $28.

A household’s energy bill would rise by $175 a year.

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Another incentive might be a hike in the tax on gasoline.

Americans pay a much lower gas tax than Europeans pay.

The figure shows the stark difference between the United States and the United Kingdom.

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Why don’t we have more aggressive caps and stronger incentives to encourage a larger reduction in emissions?

There are three reasons.

First, many people don’t accept the scientific evidence that emissions produce global warming.

Second, the costs are certain and would be borne now, while the benefits would come many years in the future.

Third, if current trends persist, by 2050, three quarters of carbon pollution will come not from the United States but from the developing economies.

externalities: pollution, education, and health care

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positive externalities

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